Instead, the Fed’s new approach is a temporary policy to keep interest rates low for longer, to make up for the inadequate nominal GDP growth that has occurred since 2008. Once the nominal GDP growth shortfall has been eliminated, it will be appropriate to again conduct policy much as was done before the crisis. That means ensuring a long-run inflation rate of 2% in terms of the PCE (personal consumption expenditure) deflator, and an average unemployment rate that is consistent with price stability.

Once we shift to NGDPLT, there won’t be any going back, because NGDPLT is far superior to inflation targeting. Whenever inflation and NGDP diverge sharply, the Fed will be under tremendous pressure to target NGDP, not inflation. For instance, if inflation rises to 2.8% due to an oil shock, and output growth falls from 2.5% to zero, the Fed will cut rates, not raise them as inflation targeting would imply. Eventually central banks will stop paying attention to inflation.

I would add that Woodford’s preferred interest rate policy instrument is also obsolete. In the next recession, and probably the one after that, interest rates will again fall to zero. Indeed the only real suspense is whether they’ll be able to rise significantly above zero before the next recession hits. In the US in 1937, Japan in 2001, and the eurozone in 2011, rates had barely nudged above zero before the next recession hit. Ryan Avent has an excellent post discussing this issue.

[BTW, unemployment in the eurozone rose to 11.8% today, 400 basis points above the US. As bad as Fed policy has been, it’s far better than ECB policy. The Fed is also doing a much better job of keeping GDP deflator inflation close to 2%]

We need a new policy instrument, one that doesn’t become mute when nominal rates fall to zero. We could use the monetary base (QE), but I would prefer pegging the price of NGDP futures contracts. And then adjusting the monetary base as required to keep the Fed’s net position in the NGDP futures market close to zero.

Recessions are when you really, really need a monetary policy instrument that is effective. Yet the preferred Keynesian instrument (short term nominal rates) locks up at the zero bound. Because it is not likely to be effective in future recessions (given the secular decline in real interest rates) the Keynesian policy instrument is now obsolete. So is the preferred new Keynesian policy target—inflation. NK policy-making did a reasonably good job during the Great Moderation. But only market monetarism can guide policymakers through the much more difficult challenges of the 21st century.

Update:Marcus Nunes agrees that NGDP will not be just a temprorary expedient, and has a much more insightful take on what’s going on.

For instance, if inflation rises to 2.8% due to an oil shock, and output growth falls from 2.5% to zero, the Fed will cut rates, not raise them as inflation targeting would imply. Eventually central banks will stop paying attention to inflation.

I think another unfortunate part of that article is that they seem to associate low interest rates with loose money.

They write:

“Instead, the Fed’s new approach is a temporary policy to keep interest rates low for longer, to make up for the inadequate nominal GDP growth that has occurred since 2008.”

Keeping interest rates low for longer “in order to” make up for the inadequate NGDP growth since 2008, sounds like they are believing money is loose insofar as interest rates remain low. The longer the Fed keeps rates low, the longer they are supposedly expansionary.

But I thought Friedman said that low interest rates usually mean money has been tight? If that is true, then Woodford and Mishkin would be incorrectly inferring that the Fed is keeping money loose by keeping interest rates low.

Dr. Sumner, I got your reply in the previous post, when you clarified that they may distinguish between short and long term rates, in that low short term rates tends to raise long term rates. Thanks for that. I asked some more questions in that other post, because I am not clear on the details and was hoping you’d help.

But here, I will just re-ask the most significant question that addresses the main confusion I have:

If Woodford and Mishkin argue that low short term rates are associated with loose money, which tends to raise long term rates, my question is why? Why doesn’t loose money raise both short term and long term rates? Why are low short term rates associated with loose money, as opposed to high short term rates?

The only explanation I can think of, and correct me if I am wrong, is that the reason loose money is associated with low short term rates is because the Fed is doing OMO in short term securities under “normal” circumstances. Thus, short term rates contain a negative interest rate adjustment due to the Fed’s purchases, whereas long term rates do not contain any negative interest rate adjustment due to any Fed purchases, which is why long term rates tend to be high with loose money (via OMO of short term securities).

If this is correct, then shouldn’t we expect loose money to be associated with low short term rates and low long term rates, if the Fed is engaging in OMO of both short and long term securities?

I imagine that if the Fed was the ONLY buyer of short term and long term government securities, they could pay any prices they wanted, and thus put rates anywhere they wanted. They could pay such that the yields are zero, despite the fact that inflation is very, very high, and consumer prices are rising very fast. In this extreme scenario, low interest rates is definitely associated with loose money.

If that makes sense, and I hope it does, then I am thinking that in less than 100% Fed ownership scenarios, there is still a downward pressure on interest rates with “loose money”, it’s just that the loose money hasn’t yet been reflected in final output prices, which explains why the positive percentage of non-Fed treasury investors have not priced in a high inflation component into interest rates. For while the Fed’s activity has been very active since 2008, it hasn’t translated into high consumer price inflation.

Once the money the Fed has created since 2008 is expanded in the maximum way it can, through increased bank credit, and so on, and consumer prices rise, then I expect to see both short term and long term rates rise, as long as the Fed doesn’t double down and increase its OMO to pull rates back down.

“Because it is not likely to be effective in future recessions (given the secular decline in real interest rates) the Keynesian policy instrument is now obsolete.”

OK. Lets say the natural rate is from here on far enough below zero so that the policy rate can never be above zero again. In that case, bonds and the base will *always* be equivalent assets and QE, present or committed, can never have any effect. The effectiveness of QE is *intrinsically* linked to a future state of the world in which money and bonds are *not* substitutes, the expectation of which has current effects. I.e. it is *exactly* equivalent to expectations of economic impacts of future non-zero rate policy.

The size of the balance sheet during the period in which the short rate is a zero has no impact on *anything*.

[I misspoke in my last comment on the previous post when I said that at any moment there is a mapping from any short rate to the quantity. What I should have said is that there is a mapping from any *non-zero* short rate to the quantity. And when the short rate is zero, the quantity is irrelevant.]

“…difficult challenges of the 21st century.” Well, the fiscal fighting between liberals, conservatives, libertarians, and the tribe of Aspergers is certain to be brutal. It always is. But has anyone given any thought to what monetary challenges would exist in a post NGDPLT world? What do the Central Bankers of Australia and Israel fret about these days? Exchange rates? Transmission mechanisms?

“We could use the monetary base (QE), but I would prefer pegging the price of NGDP futures contracts. And then adjusting the monetary base as required to keep the Fed’s net position in the NGDP futures market close to zero.”

How will the Fed guarantee a positive return/yield on these futures contracts? If the futures yield is zero, then investors may as well hold cash, or government bonds.

Geoff, Low short term rates don’t mean money is tight, it means money has been tight (in most cases.)

Because Woodford thinks in terms of interest rates, he is forced to assume that easier money means holding interest rates down for a longer period of time. But he does understand the criticism you make, which is why he wants to hold down rates until certain targets are hit, not simply for an extended period of time. Otherwise you could easily slip into the Japanese situation.

K, I agree that if rates are always zero then cash and bonds become perfect substitutes.

But they are not always expected to be zero, hence OMOs can have an effect. Even if rates are currently zero, there may be some level of the base today that boosts AD, as cash and interest bearing long term Treasuries are not perfect substitutes. And as long as rates are expected to rise, then long term rates will be above zero.

The fact that there is a “mapping” between the base and short term interest rates is not very interesting. There is also a mapping betwen the base and the price of zinc.

Doug, I’m glad that Evan will be joining the board this year.

Geoff, They would not guarantee a positive rate of return, but they would pay a high enough interest rate on margin accounts to assure that the market is heavily traded.

“Geoff, Low short term rates don’t mean money is tight, it means money has been tight (in most cases.)”

I guess I don’t see the difference between those two, because as soon as you observe what “current” monetary policy is, it immediately become historical and a “has been” truth. If you say money IS loose, or money IS tight, based on observations, those observations are going to necessarily be of historical information, not the information now…now…now. Does that make sense?

Putting aside that for a moment, I have another question: Doesn’t “has been tight” = “currently loose”?

The one is defined by the other, are they not? For aren’t “tight” and “loose” relative to some standard? If you say “money has been tight”, I immediately think OK, “tight” it is, but relative to what standard? The standard, given that I see calls for 5% NGDP growth, which is based on past historical successes, is the “good” status quo. Thus, the standard for “has been tight” seems to be relative to the current situation, because the current situation is again pretty much the status quo in terms of NGDP growth. Is that right? NGDP growth is around 4% now, which is not too bad, and so isn’t that the standard for why we say “money has been tight” during 2008-2010?

Suppose in a different world money “has been tight” at X%, and continues to be tight at some X% in “the present”, and X% for the foreseeable future. At some point, money is going to be neither loose nor tight, because the standard as the status quo overlaps the “has been” observations. After some time, should there again be any temporary change to money, then money will be “loose” or “tight” based on the standard of the status quo again, which is equal both before the change and after the change, since the drop was temporary.

So what I am thinking, and correct me if I am wrong, is that we say “money ‘has been tight’ since 2008-2010” because it’s lower than the status quo of 4-5%, which was had prior to the 2008-2010 drop and after the 2008-2010 drop. And, I am thinking that short term interest rates being low now is associated/correlated with the more or less non-tight 4% NGDP growth money now.

I guess what I am asking is how can you distinguish between low interest rates caused by:

A. current “non-tight” money; and

B. past “has been tight” money,

If both A and B are true now at this moment, and, given the above claim I made that money “has been tight” and “money has been loose” are themselves dependent on each other?

How can you disentangle them so as to reject A and adopt B, or reject B and adopt A?

You wrote:

“Because Woodford thinks in terms of interest rates, he is forced to assume that easier money means holding interest rates down for a longer period of time. But he does understand the criticism you make, which is why he wants to hold down rates until certain targets are hit, not simply for an extended period of time. Otherwise you could easily slip into the Japanese situation.”

I’m confused. If Woodford understands the criticism, that loosening money will tend to increase interest rates, then I don’t see how that can square with his “holding interest rates down” comment. He would be contradicting his own convictions. I can’t read his mind, but if you say that through his convictions he is “forced to assume” that easier money means holding down interest rates for longer, then I guess I am skeptical that he really does get the criticism. For if he did, then shouldn’t he have said something like this:

“Instead, the Fed’s new approach is a temporary policy to raise interest rates, to make up for the inadequate nominal GDP growth that has occurred since 2008.”

You probably know him better than I do, so maybe you can explain how he can get the criticism and yet say something that completely contradicts it.

“Because Woodford thinks in terms of interest rates, he is forced to assume”

Somehow I suspect it’s a mistake to believe that Michael Woodford is too mentally constrained to realize the possibilities of quantity theory.

“Even if rates are currently zero, there may be some level of the base today that boosts AD, as cash and interest bearing long term Treasuries are not perfect substitutes.”

This is not a coherent statement. You are admitting that it’s irrelevant if the Fed buys t-bills. But if it matters *which* treasuries they buy, it cannot be about “the level of the base”. What I think you are saying is that the effect has everything to do with the *nature* of the asset being purchased, what Woodford calls targeted asset purchases, and which is sometimes called “qualitative easing.” The effect of targeted asset purchases is *utterly independent* of whether the Fed buys long bonds with reserves or whether they swap t-bills for long bonds. If you want to talk about this kind of policy, it’s wrong to talk about the base or money because it has *nothing* to do with it. Instead, you have to talk about portfolio balance effects and you have to admit that the policy would be equally effective if carried out by the Treasury or anybody else in the economy for that matter. (If you still want to call it “monetary policy” that’s up to you, but it seems like a misnomer.)

Or are you saying that the Fed must *commit* to holding the extra base out to point at which the yield curve was previously implying a rate hike? If so, I agree. That’s the same thing as delaying the timing of the first rate hike (i.e. it’s forward guidance). And maybe you are saying that the *size* of the base is a signal as to when that first rate hike can occur. As I said, this is true in principle, in some universe in which the Friedman rule would also be a good guide to monetary policy. But not in our universe.

“Geoff, They would not guarantee a positive rate of return, but they would pay a high enough interest rate on margin accounts to assure that the market is heavily traded.”

I have done some heavy research using the sidebar links, regarding your proposal for an NGDP futures contract. I think I get the intuition, I am just confused on the details.

I am having trouble understanding your comment here. What do you mean “not guarantee”? Do you mean there will be a positive probability, P, that the return will be positive, and some probability, 1-P, that the return will be zero? What is the reason for the fluctuation and non-100% probability for either positive or zero return? Who or what is generating the fluctuations?

If there is going to be a positive return on the futures, then the price must fall, so that the par value of the futures contract, once sold, generates a positive return on the investment. Since the Fed has full control of the price, it means the Fed will have to choose how much return to give to futures investors. What does this return have to do with the actual or market forecasted NGDP? If the Fed is determining everything, where is the “targeting the forecast”? I don’t see how the futures contracts would reveal market forecast information, unless the futures contracts are free to fluctuate according to market supply and demand forces.

So how are these market forces represented in the futures prices, if the futures prices are determined by the Fed?

Also, why would there be margin accounts at all? Margin accounts are needed for ensuring that the middleman who connects futures traders is guarded against counter-party risk (investors on the short side of the futures contract). If the middleman AND counterparty is the Fed itself, counterparty risk would be essentially zero, and so there would be no need for a margin account.

But let’s assume that there will be a margin account for futures investors. Suppose then that investors forecast a 6% NGDP next year. If the price of NGDP futures is fixed, and the only thing generating a return is interest paid on margin accounts, then how will the Fed know the market’s forecast of NGDP, if the market can’t make the futures contracts – which the Fed is supposed to observe to find out the forecast NGDP in order to set policy – fluctuate according to market forces?

I don’t see any way for any market information to get into these futures contracts if the Fed is setting the price for them, and the Fed is setting the interest paid on margin accounts. These contracts would, as far as I can see, become just regular old fixed income securities (i.e. Fed bonds) bought and sold by the Fed, price and yield set by the Fed, and containing no market information.

I would say that compared to the current regime, it’s more counter-cyclical.

But inflation, IMO, is inherently pro-cyclical, and NGDPLT doesn’t escape that. I think I recall reading that Sumner said NGDPLT would not stop recessions, nor would it have avoided the housing bubble.

It’s been several years now, but once upon a time, the Fed’s monetary policy stance was considered to be revealed by the level of short-term rates, over which it exercises considerable influence. Low rates meant “loose”, high rates meant “tight”.

Since Between October of 1990 and December of 1998, the Fed changed the federal funds rate 77 times, usually by a quarter point, but occassionally by more. The reaction of long-term rates was overwhelmingly ambiguous. Some stats guy can pore over the data, but I see nothing. For example, on 7/2/92, the Fed cut the rate 50 bps, and the 10-year bond fell 17 bps, whereas a 50 bp cut in the short-term rate on 1/3/2001 caused the 10-year bond to spike 22 bps.

I submit there is more in Heaven and Earth than is explained by your philosophy, Horatio.

Of course there’s no going back; there never should be a going back. Inflation targeting makes no sense at all. Different goods respond differently to different increases in the money supply so a CPI of 3% can be highly misleading. In reality, money could be much easier/tighter than what the CPI shows.

We’ve had 30 years of falling interest rates, why won’t they rise again? Pendulums swing in two directions. With the shocking attitudes about creating money taking hold, would it really be surprising to see bond yields reverse?

Ben Cole,

I understand where you’re coming from emphasizing real growth. The people on the other side are arguing against inflation for the same reason. I believe that inflation is the biggest detriment to real growth in the medium to long run. Savings creates capital investment which, along with entrepreneurship, creates real growth. Inflation is the worst tax on saving possible. As Warren Buffet says,

“The arithmetic makes it plain that inflation is a far more devastating tax than anything that has been enacted by our legislatures. The inflation tax has a fantastic ability to simply consume capital. It makes no difference to a widow with her savings in a 5 percent passbook account whether she pays 100 percent income tax on her interest income during a period of zero inflation, or pays no income taxes during years of 5 percent inflation.”

If there is no opportunity cost for holding base money, then the “demand” for base money is unlimited and increasing the base is not a monetary easing.

Printing money goes “mute” at exactly the same times when interest rates go “mute”, because they are not two different policy instruments; they are the same policy instrument.

If the money printing instrument hadn’t gone “mute”, we would have had hyperinflation, since the base is far larger than it needs to be. (Monetarists try to explain this by saying that the demand for base money has increased. See first paragraph).

Scott, I agree that an NGDP target is superior to an inflation target, however I am less convinced of the assumption of equilibrium in credit markets prevailing. The 5% NGDP target makes total sense if credit markets are in equilibrium, however my empirical research suggests that equilibrium is a rarity in the world of credit. I’d love to get your comments on my piece. Hopefully I have represented your excellent argument in the correct way.

If have been reading your blog for quite a while and I am thankful for your effort to explain us the logic behind NGDP targeting. I understand that NGDP targeting is superior compared to inflation targeting when it comes to supply shocks, but I fail to see a persuasive argument on what mechanism make it far more efficient in the time of the current crisis (negative demand shock?). Could you explain to me or direct me to the posts where you explain how boosting nominal GDP using monetary policy can provide a kick start to REAL economic growth (is there any paper on this?). I understand that one mechanism could work by deflating real debts with inflation but it seems to me that one would need a lot of inflation to do this (i did some basic ceteris paribus calculus). Other mechanism, if I understand you correctly, work through asset prices. Could you explain more about this other mechanism or any alternative mechanism through which NGDP targeting works better than inflation targeting?

“Mute” refers to signaling. Base money can continue to increase though open market purchases as long as there are assets that can be bought.

Short term interest rates cannot be driven below zero.

Expanding base money is not “mute.”

It could, however, be lame. And that is what you are arguing. You are claiming that an increase in base money that does not reduce “the” interest rate will not impact spending on consumer or capital goods.

If the only asset that exists is a single type of bond, then that might be true.

But when there are many finanicial assets, and the central bank targets the yield on one of them, that particular yield might be driven to zero. Further, it might be that purchases of that paricular asset might not impact spending on output. However, if the central bank can purchase other assets, then those interest rates will be driven down too, which can impact spending on output.

You are limiting your framing on the issues based upon what central banks like to do–keep short and safe interest rates stable, and make periodic changes to avoid macroeconomic problems. Also, they prefer to buy and sell short and safe assets.

Congress is apparently nuts for writing up details about coin design. The typical subsection in the relevant law describes some coin in detail, and then repeats language each time about selling the coins for more than the bullion value, enough more to cover the costs of production.

The platinum coin section is in there with the rest. The platinum coins are described as “bullion coins,” rather than ciculating coins. But the detailed description of what they must look like and the boilerplate about selling them for more than the bullion enough to cover costs is not there.

The other kind of coins are circulating coins. There is all sort of detail about what they are made of and what they look like too. But they are not “sold” at a price higher than the “bullion” cost enough to cover distribution. The are issued into circulation at face value.

If I were going to challenge the legality of the platinum coin, I would say that it is a “bullion” coin and not a circulating coin.

If I were going to defend the legality of it, I would say that if Congress wanted to specify that it be sold for more than its bullion value (rather than made into a new denomination circulating coin,) then Congress needed to say that. Just calling it a “bullion coin,” was not enough.

I would also argue that the alternative is to mint 1.4 trillion one dollar coins, which will cost about $300 billion. A one trillion dollar platinum coin will just save money.

I also think that $100,000 platinum coins (or $10 million) or something, would be more suitable.

Please understand that these proposals are to make it a circulating coin. The proposal is to provide this coin to the Fed in return for a credit to the Treasury. It will be accounted for as a profit to the Treasury.

The same thing could be done by issuing a trillion of the ordinary dollar coins. Or 2 trillion half dollars. Or 4 trillion quarters.

Yes, except for the reality that the market determine interest rates, and interest rates reflect inflation, or inflationary expectations. No one is forced to save, or be passive savers.

In the days of regulated passbook interest rates (and I am old enough to remember) maybe there was truth in the idea that inflation robbed savers.

But savers today choose their form of saving, and take risks like any other investors, whether in real estate or equities, or convertible bonds, or starting up a restaurant etc.

The idea that savers are a sacrosanct group that warrant protection against market vagaries or inflation is just silly.

But the truth is everyone takes a risk, and judges the risk, and decides the risk is worth it when they make an investment, or pack money into a passbook account.

Beyond that, if we are to reward some group, I would think we would reward those who risk capital to form businesses, not rent-seeking passive savers.

Lastly, the world has a capital glut. Even in the USA, savings deposits have swelled by $3-$4 trillion since 2008.

The problem is not a shortage of capital but a lack of demand.

The idea that we have to protect savers to help capital formation is older than the telegraph, and just as relevant.

The fight ahead will be to avert zero-bound in the USA, and perma-zero-bound inflation.

See Japan. They have avoided inflation for the last 20 years. The results have been devastating for everyone from equity owners, to real estate owners, to wage earners. We are talking 80 percent declines in values. We are talking about an economy that is smaller today than in 1992, measured nominally.

I don’t know what is the ideal rate of inflation, I don’t know why 2 percent has become sacrosanct in some circles, or why zero percent (how you measure that is another trick, btw) is worshipped in other circles.

I know I would like robust real growth, and I really don’t care if inflation is 3 percent of 5 percent or 2 percent.

Expanding base money signals that the central bank is in a ‘dovish’ mood, but it doesn’t signal that the CB has changed its target. In particular, doubling the monetary base doesn’t signal that the CB has doubled its price level target, or anything like that.

Buying assets can be helpful if the markets are in chaos (e.g. there are forced liquidations going on), but if markets are calm, then I don’t think it does much. In any case, this has nothing to do with the monetary base, since it would work equally well if the CB emitted bonds rather than money.

Geoff, I call money tight when it is expected to lead to below target NGDP growth. Regarding Woodford, I think you need to distinguish between short and long term rates. They often go in opposite directions when monetary policy changes. Lower short term rates can raise long terms rates. When that occurs you generally have a monetary easing.

K, You said;

“This is not a coherent statement. You are admitting that it’s irrelevant if the Fed buys t-bills. But if it matters *which* treasuries they buy, it cannot be about “the level of the base”.”

You are confusing several issues. One issue is wherher T-bills become identical to cash at the zero bound, or just close substitutes. Everyone agree that swapping cash for cash has no effect, unless it impacts the future expected level of cash (which it might.) However there is reason to believe that cash is not identical to T-bills, as cash can be stolen and T-bills cannot. Reserves might be identical, but of course there is no zero lower bound on IOR.

The second point of confusion relates to the role of a larger base. Suppose cash and T-bills are perfect substitutes, but cash and 5 year T-bonds are not perfect substitutes. Then in the short run the relevant “monetary base” is the entire stock of cash, reserves and T-bills. Indeed T-bills esentially become large denomination currency notes. Now suppose we hold T-bills constant, and increase cash plus reserves. In that case with an open market purchase of T-bonds we have increased the total of cash plus reserves plus T-bills, and hence their value will fall relative to other goods services and assets.

And that is not “unconventional monetary policy,” as the Fed often holds T-notes on its balance sheet, even during normal times.

I think you guys are playing games with terminology. You claim that T-bills become de facto money at the zero bound. But then if monetarists add T-bills to the base at the zero bound, and talk about changing the stock of “money” including T-bills, you refuse to call that monetary policy. That’s just silly. If you are right that T-bills are money at the zero bound (and I’m not convinced) then you can’t have it both ways. Any OMO that adjusts the stock of T-bills plus currency plus reserves is monetary policy.

There’s also this silly game to first deny that OMOs work at the zero bound, and then when a swap of casd for 5 year T notes does work, Keynesians say that’s not really monetary policy, even though swaps of cash for T-notes have been called monetary policy throughout all of modern history. I have no interest in these word games. What matters is whether QE can be used to hit a NGDP target. It can.

The same is true of temporary vs permanent base injections. It’s always been 100% true that temporary base injections are ineffective, even when not at the zero bound. But people like Krugman make it seem like it’s some sort of great insight, which discredits the QT.

The real issue is the same as it’s always been: When monetary policy is expected to hit its NGDP target, how big is the demand for base money? That’s the issue the Keynesians seem unable to grapple with. They see low interest rates as a hurdle to overcome, I see them as a symptom of failed monetary policy.

Geoff, The NGDP futures contracts are risky because the actual future NGDP may be more or less than the target NGDP.

Brian, Markets respond to new information. Most changes are expected. Those that aren’t may be more or less expansionary than expected. Good economists have never considered rates to be a good indicator of the stance of monetary policy. During hyperinflation rates are quite high.

Saturos, Yes, I think I mentioned Copernicus in a previous post.

Ben, Great comment!

John, Obviously we might see rates rise. But consider that the factors that caused that 30 year downtrend in real interest rates (increasing Asian savings plus worsening demographics), are likely to get MUCH WORSE in coming decades. So although rates will rise modestly after the recession, I don’t see big rises ahead.

Max, I’ve addressed that in many posts. The real question is “what is the demand for base money when NGDP growth is expected to be on target?” Keynesian seems to believe the answer is “infinite,” but it isn’t. Indeed it isn’t even very high. Google my “wrong end of the telescope” post. Also see Bill’s comment.

Tom, I think 5% NGDP growth is optimal even if credit markets are not in equilibrium. I am dealing with failures in the labor markets.

Vasja, The mechanism is sticky wages. Because nominal hourly wages are sticky, more total nominal income leads to more hours worked.

“You are confusing several issues. One issue is whether T-bills become identical to cash at the zero bound, or just close substitutes.”

First you said that short rate policy can never work again because we *will* be at the ZLB, *but* that QE can work because eventually we *wont* be at the ZLB and we can buy non-zero yield instruments. So the eventual exit can work for market monetarists, but it can’t work for Keynesians. But now you are saying that even if we never exit the ZLB, QE can work and we just need to buy zero yield t-bills. Who’s moving the goal posts? My answer, BTW, is that reserves and t-bills are exactly equivalent. I’ll be happy to discuss the reasons (which mostly have to do with bank capital treatment).

“It’s always been 100% true that temporary base injections are ineffective, even when not at the zero bound.”

100% false, actually. If you inject money above the ZLB, the short rate will fall. The economic effect is proportional to the size of the rate change, and the length of the temporary period. In an efficient clearing system like Canada’s, an injection of even a few *million* dollars of base above market demand would cause a collapse of the interbank rate to the level of IOR (which, as is the tradition in our debates, we’ll assume to be zero). Note that this is a miniscule fraction of the base and it has huge macroeconomic consequences. The difference between a hugely stimulative and a hugely contractionary base is so small as to be statistically undetectable compared to random day-to-day changes in base due to fluctuations in money demand.

Even within the relatively inefficient Fedwire/Fed funds system, a change of well under 1% in the size of the base would cause the short rate to go either to zero (in case of an increase) or infinity (decrease), i.e. would result in interbank payment failure. This is why, in any remotely efficient clearing system, it is impossible to target the base. The money demand fluctuates widely on any given day, and the short rate is *hyper*sensitive to the level of excess reserves.

This ties in with your claim that the relationship between the short rate and base is like the relationship between either of those and the price of bananas (or whatever). This is simply not true. When the interbank rate is *not* the same as IOR, the Fed *cannot* simultaneously control the quantity of reserves and the overnight rate. If banks have more reserves than they want, they will dump them in the Fed Funds market and the rate *will* go down until the equilibrium reserve demand is restored. Fed Funds *is* the cost of holding excess reserves overnight and you can’t simultaneously control the quantity and the price.

“When monetary policy is expected to hit its NGDP target, how big is the demand for base money?”

If we knew the answer to that question we’d just follow some Friedman rule and grow the base at the required rate. I have a proposal: You tell me a rule for modifying the base as a function of NGDP. Lets start at our first impact with the ZLB in 2009 and assume a target NGDP level of 5% per year and 100% credible commitment. State, if you will, your policy in terms of percent annual changes in the base as a function of the cumulative NGDP shortfall.

So we don’t waste too much time going back and forth, let me explain why I think you will fail. Eventually you will want to tighten policy, in which case the market short rate *will* rise above zero. At that unknown point in the future, the base will be some size. In order for your tightening to have any effect, it will have to induce an increase in the short rate because the short rate has a *huge* impact on all bank lending and deposit rates and therefore on the economy. In fact, in order to stabilize the economy, you will need to effect an equilibrium short rate within one or two percent of the nominal natural rate.

Here is the very important point: that nominal natural rate implies some level of the base that is *totally* unknown but some extremely precise number that varies from day to day. No matter what the level of base was back when you were at the ZLB, you will suddenly have to bring it back to some very precise level that is *only* given to you at any given moment by looking at the market interbank overnight rate. While at the ZLB you will have *no* idea what the quantity will be that will cause that rate to occur. Likely you will have excess base by tens or hundreds of billions of dollars and you will suddenly have to fine tune the base within tens of millions causing settlement failure if you are even slightly wrong on the low side. And you propose to do this without looking at the short rate.

“Geoff, The NGDP futures contracts are risky because the actual future NGDP may be more or less than the target NGDP.”

It sounds like that would make futures contracts a guaranteed loss. If target NGDP is 5%, and I know that the Fed can and has committed to unlimited creation (or destruction) of money to hit that target, why would I ever bet against that? And clearly, as you have explained it the Fed takes the other side of every trade, so you’re always in the position of betting against the Fed. Even if you guess the direction of NGDP movement correctly, you know the Fed will step in to move it back to the target.

I think a better idea would be to still have the NGDP target, but to have the futures contracts linked to inflation. The premise in that scenario is that speculators will effectively be betting on the ratio of inflation to RGDP, because they know what the NGDP growth will be. Then you have a self-correcting market mechanism.

If I misunderstood the proposed functioning of your futures market, Scott, then I apologize. Even if I have, I should think it’s a worthwhile conversation, because finance professionals are going to ask questions that economists don’t always care about. One of the axioms traders like to use is, “don’t fight the Fed”. I think your system, and explanation of same, has to make it clear that speculators and hedgers are not being asked to bet against the Fed.

“Geoff, I call money tight when it is expected to lead to below target NGDP growth.”

“Regarding Woodford, I think you need to distinguish between short and long term rates. They often go in opposite directions when monetary policy changes. Lower short term rates can raise long terms rates. When that occurs you generally have a monetary easing.”

Yes, that’s what we are talking about. I was confused as to why that is the case though. Why don’t both long and short term interest rates rise when inflation expectations go up, and why don’t both short and long term interest rates fall when inflation expectations go down?

Also, is it really due to short term rates that long term rates go up or down? You seem to be suggesting that a change in short term rates causes long term rates to change, and change in the opposite direction to boot when there is monetary easing. As a bond investor, or bond seller, why would you agree to, say, a higher long term rate, if there is a fall in short term rates? If it is because it is due to the assumption that falling short term rates signals looser money, then we’re back at my question of why short term rates fall instead of rise when money is made more loose.

Can you help me understand this?

“Geoff, The NGDP futures contracts are risky because the actual future NGDP may be more or less than the target NGDP.”

OK, but such riskiness should manifest in a price that is contained in the futures price itself. It’s not enough that what the futures contract “represents”, i.e. NGDP, can differ in terms of expectations compared to results. No investor can buy or deliver “NGDP”, the way investors can buy or deliver oil or wheat that underlie oil and wheat futures.

So if NGDP futures prices don’t change, and the return NGDP futures investors receive is a function of the discretionary interest rate the Fed pays on margin accounts, how will the riskiness you speak of be translated by the market into NGDP futures prices, such that NGDP futures investors are indeed exposed to risk in the NGDP futures investment? If the risk between actual and expected NGDP is not translated into futures prices, then investors will not be exposed to such risk.

I am not sure how the NGDP futures investors will be exposed to this risk, since they’ll be exposed to that risk whether they invest in NGDP futures or not, and buying NGDP futures will only give the return the Fed itself chooses to set (via the interest payments on margin accounts).

In other words, how can the risk of the volatility between expected NGDP and actual NGDP get priced in the futures price, when futures prices are fixed and unchanging by definition in the model?

“In that case with an open market purchase of T-bonds we have increased the total of cash plus reserves plus T-bills, and hence their value will fall relative to other goods services and assets.”

These are portfolio balance effects. You are withdrawing bonds and increasing money equivalent assets. The two are very close substitutes, so to the extent that there are effects on assets and the general economy, they are very small. Furthermore, as I have argued before, portfolio balance effects are contractionary if you are removing negative beta assets from the representative investor (which is why I believe markets fell on every operation twist announcement). Anyways, if you want to talk about portfolio balance, we can. But it will really confuse the debate if you persist in using words like base and quantity to describe what you are doing. Nobody will understand what you are saying since nobody will think you mean T-bills when you say “base”.

“But then if monetarists add T-bills to the base at the zero bound, and talk about changing the stock of money including T-bills, you refuse to call that monetary policy. That’s just silly.”

Ultimately, of course, it has nothing to do with terminology. These arguments are really about whether you can claim the usual advantages of monetary over fiscal policy when you extend the definition to targeted asset purchases, especially private assets. Since you inevitable end up favouring particular asset classes over others, it smacks of bailouts. Is there a difference between Fed stock purchases and TARP? That, at least, is why I object to arbitrary expansion of the meaning of “monetary” policy.

But it’s also about theoretical clarity. It’s important to maintain clear logical distinctions between short rate policy, QE, and targeted purchases of government or private assets. Defining monetary policy as whatever some particular institution in some jurisdiction happens to be allowed to do is not going to advance the debate.

Yeah, the transcript is a goldmine for seeing the impact (or lack thereof) of market monetarist thinking. My favorite part was Brad DeLong framing the recession as a collapse of NGDP growth expectations. My second favorite part is Paul Krugman talking about the difference between this recession and the last recession (and notice how he assumes that zero interest rates mean easy money):

“The previous [recessions] in the mid-1970s and early-1980s were associated with tight monetary policy, very high interest rates, and collapses in housing investment driven by tight monetary policy“”which, of course, sprang back as soon as the Federal Reserve decided that the American economy had suffered enough.

This time is different. This time [the Great Recession] came spontaneously. This time it came in spite of drastic cuts in interest rates to essentially zero.” (emphasis added)

Or maybe this time isn’t so different, and the Great Recession, like all recessions, was caused by tight monetary policy?

“So if NGDP futures prices don’t change, and the return NGDP futures investors receive is a function of the discretionary interest rate the Fed pays on margin accounts”

You don’t have the economics of the contract right. Margin has nothing to do with it. Assume that traders, for example, post treasury bonds as margin collateral and they maintain the full economic benefit of ownership of those treasuries. Margin accounting never has anything to do with futures evaluation.

The contract settles on the actual level of NGDP. The profit, to very close approximation, is equal to the difference between the level at which the futures trade was entered into and the level at which it settles in the end. Just like a Eurodollar (interest rate) or pork belly future.

If the price of the contract never changes, it’s because NGDP ends up exactly on the Feds target and the market was always priced with that expectation. That won’t happen, but if it did it would obviously be consistent with perfect success in the Fed’s policy.

I would otherwise ignore your post, but in the interests of being charitable and open-minded, I’ll consider what you wrote (next time please don’t go around accusing people of things on the basis of faulty or incomplete information. It’s highly uncouth).

“The contract settles on the actual level of NGDP. The profit, to very close approximation, is equal to the difference between the level at which the futures trade was entered into and the level at which it settles in the end. Just like a Eurodollar (interest rate) or pork belly future.”

“If the price of the contract never changes, it’s because NGDP ends up exactly on the Feds target and the market was always priced with that expectation. That won’t happen, but if it did it would obviously be consistent with perfect success in the Fed’s policy.”

By definition, Dr. Sumner has modelled NGDP futures prices as fixed and not changing. Please visit the sidebar and research the links that deal with his work on NGDP futures.

“next time please don’t go around accusing people of things on the basis of faulty or incomplete information. It’s highly uncouth”

You’re right, I haven’t read the actual proposal. I just assumed it made sense (It *could* make sense), and that you weren’t getting it. But if it is as you say, then it doesn’t make much sense and I apologize.

“The NGDP futures contracts are risky because the actual future NGDP may be more or less than the target NGDP”

that means to me that the NGDP futures contract *settles* on the future value of NGDP (obviously!). If it *trades* at the target value but *settles* on the *actual* then investors who hold the contract until settlement make the difference between target and actual, no?

I agree that it is unlikely to work that way because it would permit *enormous* arbitrage opportunities as the actual value of NGDP becomes inevitable. But it is pretty clear as a first approximation.

“You’re right, I haven’t read the actual proposal. I just assumed it made sense (It *could* make sense), and that you weren’t getting it. But if it is as you say, then it doesn’t make much sense and I apologize.”

I think you now understand why I am asking questions about it. I don’t get it either.

“Anyways, when Scott says”

“The NGDP futures contracts are risky because the actual future NGDP may be more or less than the target NGDP”

“that means to me that the NGDP futures contract *settles* on the future value of NGDP (obviously!). If it *trades* at the target value but *settles* on the *actual* then investors who hold the contract until settlement make the difference between target and actual, no?”

The way I see it is this: In order for an NGDP futures contract, indeed any futures contract, to “settle” on a price at maturity, is for there to be a market mechanism that prices the futures all the time. And, more importantly, the underlying has to, at least in principle, be deliverable to the long futures speculator by the short futures speculator. If there is a futures contract on, say oil, then the understanding is that the short investor must in principle be able to deliver the oil to the long investor.

Of course, in the real world, almost all futures contracts are settled in cash, not the actual physical delivery of the underlying, but that doesn’t mean that one can replicate this process with a non-deliverable underlying (e.g. total spending on cars, or oil, or total spending on everything, e.g. NGDP) and setting up an artificial cash settlement when the future arrives as the present.

I don’t see how anyone can in principle deliver “NGDP” to the long futures investor. I also don’t see how expected NGDP can even get priced into an NGDP futures contract, since Dr. Sumner’s model has NGDP futures prices as fixed.

“I agree that it is unlikely to work that way because it would permit *enormous* arbitrage opportunities as the actual value of NGDP becomes inevitable. But it is pretty clear as a first approximation.”

In most pricing models, there is a “no arbitrage” assumption. Whether it’s accurate depends on whether investors have the same information, which “rational expectations” theory unfortunately assumes as a given.

But to address your point, if NGDP futures prices are fixed, and the Fed buys and sells unlimited futures at that fixed price, how can any NGDP futures investors gain a profit or incur a loss, due to a futures contract approaching maturity, and the implicit expected NGDP (which I don’t understand how it gets priced into a futures contract) gets compared to actual NGDP?

Suppose an investor shorts an NGDP futures contract. Suppose he does not offset this speculation at any time, and he allows the contract to expire. In a traditional futures contract, that investor will have to deliver the underlying to the long investor (facilitated by the exchange house). But how in the world can a short NGDP futures investor deliver “NGDP” to the long investor?

What Keynesians are actively against NGDPLT? Haven’t they basically conceded this point. Isn’t nearly all the opposition to this policy from the right?

I am not a prominent economist, but I have always thought of myself as a Keynesian. I currently spend a lot of my time telling anyone who will listen that we need to start doing NGDPLT as soon as possible.

“almost all futures contracts are settled in cash, not the actual physical delivery of the underlying, but that doesn’t mean that one can replicate this process with a non-deliverable underlying”

Not so. The Eurodollar future is probably the most traded futures contract on the planet. It’s a contract on the Libor value on a particular day in the future. Libor is an index of the term (3-month in this case) uncollateralized interbank dollar lending rate between banks outside the US (Thus *Euro*dollar). It’s determined by a poll of bank funding desks. No physical delivery even possible. Interest swaps contracts settle on the same index. Inflation swaps settle on a government index, as would NGDP futures and swaps. On the settlement date a delegated authority says what the settlement value is. If the market has confidence in the authority they will trade the contract.

“Suppose an investor shorts an NGDP futures contract. Suppose he does not offset this speculation at any time, and he allows the contract to expire.”

He sells $1m notional at 5%. The contract settles at 4%. At settlement he receives $1m*(5%-4%)=$10,000 from the exchange. Where it trades in the meanwhile is irrelevant. End of story.

When were Keynesian’s even *opposed* to NGDP targeting? Woodford, for one, is on record as supporting some kind of “output adjusted price level target” for at least ten years. NGDP isn’t *that* special as an option, other than the fact that it’s relatively easy for non-specialists to grasp. Modern Keynesian’s, above all, are opposed to liquidity traps. Anything that’s more aggressive in a slump helps us avoid liquidity traps. NGDPLT counts.

the temporary nature is as you rightly say a problem. Woodford himself always rights the need for a policy which is `history-dependent’ so that it is consistent both in and out of a constrained ZLB situation.

I would probably argue that if you could make a long run nominal anchor such as an NGDP or PL target credible, then QE would be the right policy tool since each level of the monetary base would have a unique solution for the future price level.

However if targeting the price an openly exchanged nominal GDP futures contract was required in order to make that credible, the I would agree with you.

Savers aren’t sacrosanct but they are important for the reasons I said earlier. It’s not very “nice” to want to expropriate those who are uncomfortable with risk through inflation.

On your argument that we have a savings glut right now, there is a difference between having a central bank create money and credit electronic accounts and actually deferring present consumption in order to save. I think being able to understand that difference is the tell-tale sign that someone can think economically.

Scott, t-bills (and all debt) provides income to make them an alternative to cash. At zero rates, t-bills and demand deposits become inferior to cash because of counterparty, transaction, and mark to market risks on the asset side; and because you cannot buy goods with tbills — you must first find someone with cash. Tbills — and all debt — are not equivalent at the zero bound, they are worse assets. Bills circulate, cash is hoarded. Sounds familiar…

Similarly, demand deposits can transact similar to cash — a bank could absorb a tbill as an asset and create a dd, but zero-yield demand deposits are simply derivatives on physical cash — again inferior from your vantage point. (And why would a bank hold a 10bp bill when it could get 25bp on reserves?) You– the depositor — also have counterparty risk with the bank: it could transfer deposits or give you cash, or it might have other ideas…

US 6m t-bills have 10 basis points of yield compensation versus a 30 basis point default protection cost in CDS. (What we call positive basis in the biz.) They are even worse than you’d imagine versus cash.

I also recommend the Delong Salon, especially Valerie San Diego’s contribution;

————quote————-
….When we look at this, what do we find? We were really surprised””we thought that multipliers would be higher in periods of high slack….

…everybody remembers the example of World War II. The unemployment rate was very high. Government spending increased. The unemployment rate went down to 1%. Isn’t that obvious? When I started looking at the labor market, I found that a big part of the picture was simply military conscription.

….Yes, private employment did go up some during World War II. There was some private employment effect, although I could not get it to be statistically significant. Big a part was military conscription. Thus to answer one of Brad’s questions, yes, the government could adopt a policy that would quickly reduce unemployment: large-scale military conscription. If the problem is with employment rates for young males, this is a great way to do something about that, but I don’t think anybody thinks that policy would be welfare-improving.
————endquote———-

No surprise, Krugman didn’t like that. And, he really hated Uhlig’s presentation, which started off with;

‘If you look at postwar data for the United States, government spending is simply the most cyclical macro variable that is out there. The U.S. economy got into recessions without government spending. It got out of recessions without government spending.’

Which got better after that, as those who follow Saturos link can read for themselves.

Geoff said: “The way I see it is this: In order for an NGDP futures contract, indeed any futures contract, to “settle” on a price at maturity, is for there to be a market mechanism that prices the futures all the time”

I think this is accurate. What Scott is proposing sounds more like European style options than futures, although those also have fluctuating prices. But they can only be exercised on the expiration date. Unless I just really misunderstand what he’s proposing, Scott’s system doesn’t sound like a futures market at all.

K, What I meant is that the standard Keynesian approach to monetary policy, which is adjusting the current fed funds target, no longer works at the zero bound. Perhaps other Keynesian strategies will be developed, but I’m not optimistic that Woodford’s approach would be very effective.

It makes much more sense to adjust the base until NGDP expectations are on target.

I don’t think that changes in short term rates have much impact on the economy, I see them as a sort of epiphenomenon of monetary policy. If the base injection is expected to be temporary, then any impact on rates will also be temporary, and the macro impact will be tiny. That is true regardless of whether we are at the zero bound.

You said;

“Fed Funds *is* the cost of holding excess reserves overnight and you can’t simultaneously control the quantity and the price.”

I’ve made the same comment many times. If I suggested otherwise my comment was poorly worded.

As I’ve said many times, I don’t know which level of base money is optimal. I favor allowing the market to determine the base. I oppose the Friedman rule. It’s possible that there are times where changes in short term rates will help the central bank determine how to change the monetary base to keep NGDP expectations on target. Obviously we are not currently in one of those times. The Swiss National bank seems to feel that the exchange rate helps them determine what level of base money will stabilize NGDP. (See my next post.) I doubt that’s optimal for the US, but it is at least less ambiguous than interest rates–where higher rates can mean either money is too easy, or too tight.

Geoff, The standard view is that easier money does not make short rates go up (despite higher inflation expectations) because prices are sticky and hence short rates fall to equilibrate the money market–the so-called “liquidity effect.”

The price of NGDP futures contracts can fluctuate once the central bank stops pegging them, and starts pegging the next contract. Recall that they are always pegging the NGDP contract due 12 months ahead, and only that contract.

2. get upset when monetarists start talking about changing the total stock of what Keynesians themselves consider “cash.” Obviously if Keynesians consider T-bills to be identical to currency (put aside the question of whether it is or not) then it should be part of the redefined monetary base. In that case monetary policy only “works” by adjusting the size of the redefined base, which means injecting cash and reseves in exchange for assets other than T-bills. That just seems like common sense to me.

Now this doesn’t mean T-bills and currency are in fact perfect substitutes, I regard them as close substitutes. Rather I’m simply trying to play the Keynesian game, and see where it leads. It leads (in my view) to the conclusion that you want to adjust the total stock of cash plus reserves plus T-bills.

And it makes no sense to talk about whether exchanging cash for bonds “works” as OMOs are not policies, they are tactics. The policy is defined by the target. If the Fed wants to target inflation at 2%, I’m sure there is some level of long term bond purchases that can be used as a tactic to achieve that objective.

I do not favor using monetary policy to buy private assets in the US. For smaller countries like Switzerland, it might make some sense. And even if it were considered “ficcal policy”, I’d much rather we do fiscal policy where the Fed takes zero interest loans from the public and buys equity index funds, as compared to where the Congress takes tax money and spends it on projects that they would not do if AD was on target. But this is a moot point for the US, as there is no need to the Fed to buy private assets.

Saturos, To say market monetarist thought was not represented would be an understatement. But no surprise, we’re still very much in the minority. Krugman keeps repeating this myth that the BOJ tried to inflate and failed. If they had, that would tell us something important. But it didn’t.

Anthony, I “bash” all non-market monetarists. I’m glad that NGDPLT is becoming increasingly popular, but I’ll keep “bashing” all non-market monetarists until the entire world is market monetarist. If you think I’m tough on them, read my comments on old monetarists, MMTers, Austrians, RBC-types, etc.

Masked economist, Good point.

jknarr, T-bills occasionally sell at negative yields, because some prefer them. They are safer, can’t really be stolen like cash.

“I don’t think that changes in short term rates have much impact on the economy, I see them as a sort of epiphenomenon of monetary policy. If the base injection is expected to be temporary, then any impact on rates will also be temporary, and the macro impact will be tiny. That is true regardless of whether we are at the zero bound.”

I’m confused by what you mean by temporary. Do you mean, has a definite time limit? Or do you mean reversible?

As far as I can tell, no central bank interest rate (or base quantity) actions are temporary in the first sense, and all of them are temporary in the second sense.

“In that case monetary policy only “works” by adjusting the size of the redefined base, which means injecting cash and reseves in exchange for assets other than T-bills. That just seems like common sense to me.”

No. It’s working by exchanging some kinds of risk assets for others. Zero interest rate has *nothing* to do with this. If you exchange long bonds for stocks that could have a big *portfolio balance effect*. That’s what you are talking about. The *quantity* of zero yield assets is TOTALLY IRRELEVANT. If portfolio balance works, it’s about the risky assets the Fed is keeping on its own balance sheet and which investors therefore don’t have to hold. The nominal quantity of assets (the size of the balance sheet) has no economic consequence. It’s *which* assets.

If you are at the ZLB just stop messing with the base. Whatever changes you want to make, save them for when we are no longer at the ZLB and they’ll actually affect something.

“I don’t think that changes in short term rates have much impact on the economy, I see them as a sort of epiphenomenon of monetary policy. If the base injection is expected to be temporary, then any impact on rates will also be temporary, and the macro impact will be tiny. That is true regardless of whether we are at the zero bound.”

Let me propose the following *temporary* change in the base. Suppose the CB is following your favorite policy. There currently is some outstanding base B1, and the CB expects some other level B2 of the base three years hence. By some strange decree (a legislative loophole!) an evil Neo-Wicksellian (NW) gets to be central bank dictator for three years after which the virtuous central banker (call him MM) will be restored. Before NW takes over, MM promises that the moment he gets back the reins if power, the base will be restored to B2. NW takes over and moves the short rate to 20% and holds it there for three years.

Is it your contention that whatever changes in the base occur over those three years are as irrelevant as they would be if the economy had been liquidity trapped with rates at zero for those three years, because they are temporary?

If you don’t think my experiment is fair, please propose another one that clarifies, as requested by Max, your meaning of temporary. Again, this returns to my point (that you haven’t addressed) that it simply isn’t possible to implement monetary policy in terms of the base when not at the ZLB.

No. It’s working by exchanging some kinds of risk assets for others. Zero interest rate has *nothing* to do with this. If you exchange long bonds for stocks that could have a big *portfolio balance effect*. That’s what you are talking about. The *quantity* of zero yield assets is TOTALLY IRRELEVANT. If portfolio balance works, it’s about the risky assets the Fed is keeping on its own balance sheet and which investors therefore don’t have to hold. The nominal quantity of assets (the size of the balance sheet) has no economic consequence. It’s *which* assets.”

I have no idea what you are getting at here. Is this an argument that is always true, or only at the zero bound? If it’s always true than the QTM would be completely wrong, and I don’t think even NKs believe that. The price level needs an anchor. If it’s only true at the zero bound, tell me why, as all the zero yield assets are grouped into my redefined “base.” Are you saying these assets are perfect substitutes for other assets?

You said;

“If you are at the ZLB just stop messing with the base.”

You are still getting things exactly backwards. You “mess with the base” as needed to keep NGDP growth on target. Even at the zero bound the demand for base money will fluctuate. If not accommodated (as in 1930-33) you get massive deflation, not the 1.5% inflation we’ve actually “enjoyed” under Bernanke.

You don’t mess with the base to see if it works, you mess with the base to provide just as much base money as the market says it wants to hold.

You said;

“If you don’t think my experiment is fair, please propose another one that clarifies, as requested by Max, your meaning of temporary. Again, this returns to my point (that you haven’t addressed) that it simply isn’t possible to implement monetary policy in terms of the base when not at the ZLB.”

I don’t know what you mean by this statement. Are you saying that the Fed cannot control the base as a technical matter? I disagree. Are you saying it would not be a good idea to target the base? I agree. Are you saying that actual changes on monetary policy will not (at zero IOR) necessarily involve a change in the base? I disagree.

I favor targeting NGDP expectations, and favor doing so via adjustments in the base. Keynesians favor targeting interest rates, and favor doing so via adjustments in the base. Which policy do you think is not feasible?

Regarding your three year example, obviously the word “temporary” is ambiguous. Even a quadrillion years is “temporary” in a technical sense. Sure, a massiv emonetary shock expected to last three years will matter. My hunch is that there is an symmetry, where a temporary contractionary policy expected to last 3 years would reduce NGDP by more than a temporary expansionary policy that’s expected to last for 3 years would raise it. So in that sense I agree with you on this specific example. But of course we were considering temporary expansionary policies. Even Krugman admits that temporary contractionary policies are effective at the zero bound. I suppose this asymmetry comes from the fact that a contractionary policy would bite into the hard core transactions demand for money, at least if it boosted rates to 20% (a rate that reduces hoarding demand sharply). Whereas a temporary expansionary policy at the zero bound pushes base money into the hoarding demand, which is highly elastic at the zero bound.

I’d add that this sort of experiment has never been done, so we really don’t know the effect on the real economy. In practice, we have observed tight money policies that were not expected to be reversed in three years.

Just at the ZLB, sorry. The CB can’t actually control the base away from the ZLB, for reasons I’ve discussed above (the short rate is too sensitive to the exact quantity and the total money demand is way to volatile, so they have no choice but to just control the short rate).

“tell me why, as all the zero yield assets are grouped into my redefined “base.” Are you saying these assets are perfect substitutes for other assets?”

I don’t understand this question.

“The price level needs an anchor.”

At the core of our disagreement, I’m sure. The price level has *no* anchor given our institutional setup. Money backed by bonds denominated in money does not provide an anchor. If the CB was just a fund that held real assets and changed the unit of account by simply splitting the quantity of its liabilities, then the ratio of the quantity of liabilities to the amount of real assets would define the value of money (this is a helicopter drop). But if the CB changes the quantity of its liability by using them to *buy* more assets then *both* the amount of assets *and* the quantity of liabilities are changed and therefore real value of the liabilities (money) is unchanged (this is QE). QE is *not* the traditional Humean monetary thought experiment and it has no impact on the value of money. The helicopter drop is, and does.

“Are you saying that actual changes on monetary policy will not (at zero IOR) necessarily involve a change in the base?”

Correct. Lets say the BoC revokes hand-to-hand currency so we are only left with reserves. Nothing changes, except we now have to use credit and debit cards for everything. The BoC changes rates *all the time* with no impact on the level of reserves. Total reserves, as a matter of convenience, are floored by the BoC at $25M and that’s typically exactly how much reserves is in Canadian banks on any given night. It simply doesn’t change and has to need to change when rates change. It could even be *exactly* zero, but banks would have to make sure to settle all transactions to the last penny which would be annoying. Anyways, you aren’t going to claim that $25M of anything is going to have an impact on the Canadian economy. But rates *do* have a huge impact on the Canadian economy.

Ben — Even beyond that, as someone with lots of long-term bonds (I’m starting to hedge more because I think more people will recognize Scott is right) what’s really better for me, 30 years of 5% real returns on my bonds in an economy that grows at 1%, or 30 years of 2% real returns in an economy that grows at 3%?

I don’t think that’s a hard question to answer! But everyone seems to assume there’s a real and problematic dilemma for me there.

Ok, but expected why? If because the CB said, “we’re going to reverse in the near future, no matter what”, then I would agree that a temporary change in interest rates should have little effect.

But that’s not how it works. There is no time limit. Therefore, if people expect it to reverse in the near future, it can only be because they believe rate changes are effective. Maybe you mean that it’s the threat of rate changes, and not the rate change itself, which is most powerful. I would agree with that.

Re: anchor, the anchor is whatever the central bank’s target is. If the base is small, then the assets of the CB are almost irrelevant. If the base is large, then the CB will be constrained by the value of its assets. It can’t target a price level which makes it insolvent.

I don’t even know what this means. Of course they can control the base. They can increase it a billion fold. Yes, rates might soar in that case, but so what? That has no bearing on whether they can control the base. Or is your claim that an explosive growth in the base would reduce nominal interest rates?

The rest seems to be the fiscal theory of the price level, which has no support in the data. One day you are a NK, the next an Austrian, and now a follower of John Cochrane. I can hardly keep up.

The Fed created lots of inflation during the Great Inflation of 1965-81 by printing lots of currency. Currency is not a close substitute for the assets the Fed buys, hence when they increase the stock of currency the price level rises and the value of currency falls.

Your Canadian example is meaningless because they have an IOR policy, which was excluded in my comment. The only way to affect the value of an asset is to adjust either the supply (OMOs) or the demand (IOR).

I explained it in the rest of the sentence: “the short rate is too sensitive to the exact quantity and the total money demand is way to volatile, so they have no choice but to just control the short rate.” Of course they *can* set the quantity. But if they set the quantity without looking at the short rate, the short rate will fluctuate violently between infinity and zero on an intraday basis, as I’ve discussed in many comments in the past few days. It’s not feasible.

“They can increase it a billion fold. Yes, rates might soar in that case, but so what?”

Drop, not soar, I assume.

“The rest seems to be the fiscal theory of the price level, which has no support in the data.”

No. Just explaining the difference between asset purchases and, e.g., doubling the number of outstanding liabilities of the CB *without* changing the assets. Think of Hume’s thought experiment. First imagine that each $1 coin is made of worthless metal and the quantity is magically doubled. Ignoring various real world complications, lets say the price level doubles. Now, lets say the coins are actually made of $1 worth of silver and suddenly the number of coins doubles (i.e. the backing also doubled). We expect *no* change in the price level. The number of coins doesn’t affect anything (so long as we are not consuming a significant proportion of the global supply of silver). The first case is a helicopter drop, which is what Hume was talking about. The latter case is like QE which doesn’t do much.

” One day you are a NK, the next an Austrian, and now a follower of John Cochrane.”

NK is about understanding the impact on inflation and the output gap as a result of deviations of the real rate from the natural rate. But most NK models tell us nothing about the dynamics of the natural rate. They aren’t designed to model the supply side details of the economy. I do think the Austrians have lots to say, e.g. about risk taking and creative destruction, and I also find plenty of wisdom in Minsky, Mancur Olson, Joe Stiglitz and other lefty economists, and also the Chicago school’s contributions to formal modeling of the supply side dynamic (RBC). Apart from some recent liquidity constrained models, NK says almost nothing about about the supply side, so I don’t see how we can much progress just ignoring everything but NK. How am I supposed to think about what happens to the natural rate? (I don’t follow the reference to Cochrane since I haven’t read him much.)

“I can hardly keep up”

Sarcasm, no doubt.

“The Fed created lots of inflation during the Great Inflation of 1965-81 by printing lots of currency.”

Not a liquidity trap. Rates were too *low*.

“Your Canadian example is meaningless because they have an IOR policy, which was excluded in my comment.”

If they paid no IOR, the quantity of excess reserves wouldn’t be bigger! The banks would want to hold it even less, so there would be even *less* than $25M of reserves in the system if the BoC wanted the interbank rate above zero. So if Canada cancelled hand-to-hand currency, they’d be operating with a quantity of essentially *zero*. And still setting rates and controlling the economy. Rates *matter*.

“The only way to affect the value of an asset is to adjust either the supply (OMOs) or the demand (IOR).”

Imagine there is *no* base. Just overnight loans to cover demanded payments. The quantity is always exactly zero, since for each lender there is a borrower and no need for outside money. Just debts denominated in the *unit* of account and a rate but no quantity of money. This is the interbank market, and it would also describe all real economy transactions (other than barter) in a world of no hand-to-hand currency. This is the world of the NK model, (and the world of capital asset models in finance). The QTM has little meaning in such a world. This is the limit of a “pure credit economy” and it’s basically the world that we live in, in my opinion.

Matt Rognlie once wrote a post comparing the possible economic impact of monetary effects vs direct impact of the change in the real rate (the NK effect) of a one year one percent change in the policy rate in the US economy. He concluded the direct real rate effects are vastly bigger (and for various reasons, I think he overstates the possible monetary impacts).

“I explained it in the rest of the sentence: “the short rate is too sensitive to the exact quantity and the total money demand is way to volatile, so they have no choice but to just control the short rate.” Of course they *can* set the quantity. But if they set the quantity without looking at the short rate, the short rate will fluctuate violently between infinity and zero on an intraday basis, as I’ve discussed in many comments in the past few days. It’s not feasible.”

Funny how the financial markets survived just fine prior to 1914, when there was no Fed adjusting the base. Base shocks were exogenous (from the gold stnadard.)

No, I meant “soar” not drop. Interest rates soar during hyperinflation. Who wants to lend money when it’s being debased at astronomical rates? But I guess your assumption shows how far apart we are.

The silver example depends on why the supply of silver coins increased. If it’s a new discovery of silver it could easily lead to inflation. But in any case that has no bearing on the fiat money example I was discussing.

Cochrane argues that OMOs don’t create inflation because you are just swapping one asset for another of equal value. The government’s fiscal position doesn’t change, and hence there is no reason for money to loose value. It treats cash today as if it is still backed, but by government bonds not gold. I think that theory is totally wrong. The value of cash is not related to its “backing” except in extreme cases where the central bank will be forced to print money because the government is broke. That was clearly not the case during the US Great Inflation, for instance, I’ll do a post soon.

Stiglitz’s position on monetary eocnomics can only be described as bizarre. I have the impression that even Krugman can’t follow his arguments. Read Stiglitz on the Great Depression.

I don’t follow your Canadian example. Even without currency, there is a demand for reserves to clear balances. It’s a “transactions demand” right? So that pegs the price level. If your point is that we’d have hyperinflation if we kept the Canadian base where it is and did away with IOR, I agree. But of course if we made that change we’d adjust the base. My point is that the stock of reserves would then pin down the price level (when combined with the demand for reserves.)

If you want to understand my views, start with a commodity money, and think how the price level gets pegged. Obviously you don’t use a NK theory for that. Now assume that the stock of paper base money is a sort of “paper gold,” but with one exception. Whereas more gold boosts utility, more paper money doesn’t. We get a certain amount of utility from having a paper money system, but, unlike gold which is also used as jewelry, if we woke up tomorrow morning with 10 times more paper money, we’d get the same utility, i.e. 1/10th as much per dollar. The utility comes from the usefulness of currency in transactions and hiding wealth. But its a MONETARY SYSTEM we want, a way of keeping score, the actual quantity doesn’t matter in the long run.

Regarding your last point, in a “world with no money,” there is actually money, otherwise there’d be no MOA. Bennett McCallum pointed that out, as I recall. But let’s say you keep the net balances of reserves at zero. So there is no change in the supply of MOA. You can then only control its value by changing the demand. How do you do that without IOR paid to holders of the medium of account? Maybe I misunderstood your example, but I assume that even though the net aggregate total of reserves is zero, some individuals can have positive MOA balances and others have negative. Is that right? If so, don’t you need to adjust the IOR to change the demand for that MOA, and hence its value?

Anyway, in the real world (at positive rates) most MOA are $100 bills, so for the time being it will be control of the stock of $100 bills that pegs the price level. I agree that in the distant future monetary policy will look more Woodfordian in the sense you describe (but also more MM in targeting NGDP futures prices–indeed Woodford spoke favorably of a MM forerunner by Hall (1983), which adjusted IOR automatically as needed to stabilize expected future CPI.)

I’m sure we can play duelling banjo’s on the economic history ad
infinitum. For example, you never responded to the fact that yields fell significantly during QE1. I think it’s pointless in this format. The only way to make progress on that sort of thing is with careful and complete econometric studies, rather than competing anecdotes.

“No, I meant “soar” not drop”

The front end would drop. The longer the period of the drop, the longer and bigger the subsequent period high rates to contain the resulting inflation. The initial inflationary impact is proportional to the amount by which, and the length of time for which, the forward real rate is below the natural rate.

“The silver example depends on why the supply of silver coins increased. If it’s a new discovery of silver it could easily lead to inflation.”

But that wasn’t the thought experiment. But this is probably a futile line anyways.

“The value of cash is not related to its “backing” except in extreme cases”

For the most part, this is true, the reason being that the central bank’s balance sheet is *not* independent of the government’s. Both profits and shortfalls are taken by the treasury. But nevertheless, there is a big difference between backed expansions, and totally unbacked expansions, since the latter seriously challenge the power and independence of monetary authority in case of inflation.

“My point is that the stock of reserves would then pin down the price level”

My point is that a few million dollars of reserves *can’t* be made to account for the price level. That was the point of Matt Rognlie’s piece. The direct economic impact of the real rate on the behaviour of agents in the economy is vastly greater than the cost of holding a bit of
non-interest paying base. It’s the real rate that does the job of
controlling demand in a direct fashion.

“some individuals can have positive MOA balances and others have negative. Is that right?”

Correct.

“If so, don’t you need to adjust the IOR to change the demand for that MOA, and hence its value?”

The central bank needs to control both its bid rate for cash (IOR) and its offer rate (discount rate) in order to keep the market rate (between banks) in the “channel” between the central bank’s bid and offer. But where’s the “hot potato” if all you have is loans, and no zero interest money? And how does changing the interest rate change the “value” of money if money earns interest? T-bills don’t change value when interest rates change. I don’t understand the QTM if money earns the same rate as t-bills. Doesn’t that mean that money is *always* more desirable than t-bills since it earns the same pecuniary return but also has
non-pecuniary benefits as a medium of exchange. How can the money demand have any relevance?

“I agree that in the distant future monetary policy will look more Woodfordian in the sense you describe (but also more MM in targeting NGDP futures prices-indeed Woodford spoke favorably of a MM forerunner by Hall (1983), which adjusted IOR automatically as needed to stabilize expected future CPI.)”

OK! Maybe we are closer than we think, but just don’t agree what regime the current system is in.

I think we are entirely in a Woodfordian pure credit economy, and that this is so despite the existence of zero-interest currency *because* the CB accomodates whatever supply of currency is required to match demand at the CB’s desired interest rate. And if currency *were* cancelled it would *necessarily* be so and money would just be private loans and the quantity of money wouldn’t even be in principle relatable to the price level, which would be arbitrary (but stabilized by price stickiness and rate adjustments). I admit that other, more QTM-like regimes are possible, but I don’t think we are anywhere near there.

[…] –Fed Policy: Scott Sumner comments on an op-ed by Frederic Mishkin and Michael Woodford about Fed policy. “Woodford’s preferred interest rate policy instrument is also obsolete. In the next recession, and probably the one after that, interest rates will again fall to zero. Indeed the only real suspense is whether they’ll be able to rise significantly above zero before the next recession hits. In the US in 1937, Japan in 2001, and the eurozone in 2011, rates had barely nudged above zero before the next recession hit.” […]

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Welcome to a new blog on the endlessly perplexing problem of monetary policy. You’ll quickly notice that I am not a natural blogger, yet I feel compelled by recent events to give it a shot. Read more...

Bio

My name is Scott Sumner and I have taught economics at Bentley University for the past 27 years. I earned a BA in economics at Wisconsin and a PhD at Chicago. My research has been in the field of monetary economics, particularly the role of the gold standard in the Great Depression. I had just begun research on the relationship between cultural values and neoliberal reforms, when I got pulled back into monetary economics by the current crisis.